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Monday, November 7, 2011

Startek's Star Customers

Startek makes for an intriguing value play. The company has $20 million worth of cash, but trades for just $38 million. Before the recession, this company was averaging more than $10 million in earnings per year.

Since 2007, however, Startek has been losing money. Can the company get back to its pre-2007 levels? Maybe. For those interested, there's in-depth analysis of this company and stock available here. (Unfortunately, you do have to register to access it though.)

But a major red flag for a long-term investor has to be this company's customer concentration. Startek derives more than 60% of its revenue from one customer (AT&T) and more than 80% of its revenue from its top two customers. While it's entirely possible that Startek will continue to meet the needs of these customers (in fact, it may even be probable), this is a huge risk.

If one of these customers (particularly the big one) decides to switch firms or develop the service in-house or has to shrink because of its own market positions, Startek will be left with a bunch of facilities with a whole lot of capacity. The downside risk may be great here despite the strong cash position. Of course, this risk may never bear itself out, but the ideal investments are those where risks are minimized and upside potential is high.

This company was in a similar position, and went bankrupt when its largest customer moved on. While Startek has enough cash to avoid bankruptcy, the loss of a major customer would likely destroy a whole lot of perceived value.

2 comments:

Anonymous
said...

Saj,

Glad to see you checked out SRT. It's now the largest position in my portfolio - even larger than BRKB. In my estimation, SRT has the best expected return / risk profile of any investment opportunity I'm aware of. According to my simple DCF analysis, based on Omar Samalot's reports, I estimate that SRT's intrinsic value is over $9.00/share, whereas it's currently selling for $2.61/share. That's an extremely large gap, especially considering that the company has $11.5M of cash (no longer $20M as you said in your article) and no debt. The balance sheet also provides a large margin of safety due to its $5.30 of tangible book value per share.

In my opinion you're over-estimating the risk of SRT's customer concentration. First of all, as of Q32011 AT&T is down to being 53% of SRT revenue. And if Q4 is anything like Q3, the percentage will be even lower next quarter. Clearly the trend is in the right direction, and management is keenly aware of the importance of diversifying their revenue base. You should also be aware that AT&T, while it is a single corporation, has many internal business divisions. And as SRT has discussed on their conference calls, the relationship with certain divisions is much better than others. For example, the loss of business from one of AT&T's divisions caused SRT to recently close down one of their US locations. But at the same time, they won new business from a different AT&T division. So AT&T is not quite the "single customer" it may seem to be.

But the main trend that's clearly starting to work in SRT's favor has nothing to do with its improving level of customer concentration - it's the continuous expansion of their offshore business and the downsizing of the onshore business (which increases capacity utilization and make that business more profitable). As a US citizen I realize that's a very bad thing for my country, but as a shareholder I realize it's a very good thing for SRT. These two counter-trends have caused the company's recent past financial performance, which is atrocious, to be unrepresentative of its expected future financial performance. Once the new state of affairs becomes apparent on the income statement it will be too late to invest in SRT. The time to invest is now, when the consolidated income statement that combines both offshore and onshore segments still looks very bad.

I'd like to add a further comment on this customer concentration issue.

Although many value investors think academic theories such as "Modern Portfolio Theory" and "CAPM" are worthless, there's one aspect of these theories that I think *is* useful and it applies to SRT. The risk of a company losing its primary customer ought to be evaluated in the context of an investor's complete *portfolio* of investments, not in isolation. The reason is that the probability of a company losing its primary customer is statistically independent of the overall macro-economic environment. In the language of CAPM, it's an "idiosyncratic" risk that can be diversified away.

Put in more practical terms, any non-macroeconomic (idiosyncratic) risk, such as SRT losing its primary customer, ought to be far more significant to an investor who has put 100% of his net worth into that single investment than it should be to a well diversified investor.

Here's another way to look at it: what if you could find 20 SRT-like investments, each of which has high customer concentration but otherwise looks extremely attractive from a forward-looking income statement, cash flow statement, and balance sheet point of view. Let's assume these 20 companies are all in different industries. Is this basket of stocks risky? I'd argue no, it's not. In fact, the overall basket would be extremely compelling from an expected-return/risk point of view.